StreetBeat
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Updated 10/24/97
The purpose of StreetBeat is to provide you with additional insights on the market from recognized
financial experts on (and off) Wall Street. It should be noted that the views and opinions expressed
by the panelists below are not necessarily those of Briefing.com.
This week, StreetBeat addresses the oil industry with analysts, Joseph Culp, Holly Gustafson, and
Bud Tower.
Panelists
Joseph Culp, CFA, Vice President, Energy Analyst at A.G. Edwards. Mr. Culp rejoined
A.G. Edwards in 1992 after working for the company from 1975 to 1981, and is a past
runner up in Institutional Investor's All-American Analysts survey.
Holly Gustafson,CPA, CFA, Vice President, Energy Analyst at NatWest Securities. Ms.
Gustafson has been covering the oil industry for over 15 years.
Arthur (Bud) Tower,CFA, Vice President and Research Department Manager at Howard,
Weil. Mr. Tower has a combined 15 years experience both in the oil industry and as an
analyst.
Q&A
Briefing: There appears to be a subtle shift of power happening in the oil
business with the major oil companies needing the oil service companies as
much as the oil service companies need the majors. Have the price increases
by the oil service and equipment companies impacted the major oil
companies? Do you see the price spikes continuing?
Joseph Culp: The major oil companies would obviously prefer to pay less, but they realize that they
are in an environment now where they have to pay more due to a scarcity of supply. Fortunately,
major oil companies are flush with capital, and they are finding that one of the most productive
places to put that capital to work is in deep water projects. While day rates for these projects may
appear exorbitant, they must be looked at in the context of what it actually costs the major oil
companies to find oil deposits. Though the expense of renting rigs is going up, oil companies are
discovering so much oil in deep water that they are lowering unit finding costs in the process.
Ultimately, it boils down to a value versus cost relationship, and the value derived from deep water
drilling makes the costs associated with these projects a drop in the bucket.
With respect to pricing, rates will continue to go up given that drill-rig scarcity is a fact of life in this
business. No simple undertaking, building rigs is a two-year process, and the new rigs that are being
built cost more to construct because the components used in production are more expensive, and
the rigs themselves are becoming more and more specialized. However, I don't see rates going up
dramatically from current levels. Even at current levels, oil service and equipment prices have not
been a major consequence given that the prices for oil and natural gas are far exceeding projections.
Keep in mind that oil companies were forecasting double-digit returns using $17 per barrel as a
benchmark. With oil now at $21 per barrel, the difference is simply icing on the cake.
Holly Gustafson: Demand for oil services is typically volatile and tied to the drilling budgets of the
major oil companies. High oil and gas prices in the last two years have increased the coffers for the
oil companies, both major integrateds and independents. In addition, the oil business has been in a
restructuring and cost-cutting mode since the beginning of the decade. Oil companies are now
breaking out of this and looking to expand. (Strong worldwide economies and rising demand for
petroleum products doesn't hurt). The stepped-up emphasis on drilling, particularly overseas and in
the deep-water Gulf of Mexico, not surprisingly, has increased the demand for oil services -
especially deep-water rigs. Increased demand pushes prices up. This is not a structural change in the
business, just a different point in the cycle. So far, the major oils are not reporting any significant cost
increases that effect their profitability. I think spot shortages could occur for rigs which could delay
some drilling projects, particularly for the smaller companies. However, I do not think rising oil
service costs are going to do much to change the industry trends. As long as the oil companies have
the money, they hold the reins. When and how much they decide to spend will depend on a lot
bigger and far reaching issues than oil service costs.
Bud Tower: There is no subtle shift of power in the oil business. The majors have always had and
will always have the power. We include sixteen oil companies in our universe of the majors. Their
combined market capitalization is about $700 billion. The forty-nine oil service companies we follow
have a combined market capitalization of about $140 billion. It is clear where the power lies.
The price increases from the service companies have impacted some of the oil and gas prospects,
though the impact is not necessarily profound yet. The bread and butter of US oil production is in the
Gulf of Mexico from the shelf to 600 feet (deep water drilling - 1500ft and deeper - is the future).
The economics of some of the shelf projects are being impacted by the service costs and some
projects are now rendered uneconomical.
We have not really been seeing price spikes from the service companies, but rather a steady
improvement in the economics of the oil industry as a whole. Oil companies have been restructuring
since about 1982. What we see today is a healthy industry that is well capitalized and has the ability
to reinvest in equipment. The drillers and the service companies are just now reaching replacement
cost economics.
Briefing: Recently, the Scottish exploration company, Cairn Energy,
partnered with the oil service firm, Halliburton, to develop the Sangu field off
of Bangladesh. This is Halliburton's first actual ownership interest in an
oilfield. Is this the beginning of a shift away from dependence on capital from
the majors? If so, does this pose a threat to the major oil companies?
Joseph Culp: I wouldn't call it a shift. Rather, I would deem it prudent planning for supplementary
income in the future. Oil service companies realize that a few years down the road they won't be
able to add rigs or upgrade rigs at the same pace they are today, so they're considering other
projects. While it is true that major oil companies have come to rely more on the oil service
companies, they are by no means threatened by this residual interest shown by oil service companies
in developing oilfields. The main concern of the majors continues to be rig availability, and they are
certainly willing to share a portion of upside revenue gains, via joint ventures, if that enables them to
get access to the rigs. Thus the perception that there exists an attitude of "this is my turf and you're
not allowed into it" is misguided.
Holly Gustafson: A number of changes are taking place in the oil industry in how projects are
managed, financed and owned. We are seeing a lot of joint ventures, alliances and partnering with
state oil companies. I think we will see more oil company involvement in power plant projects,
pipelines, and less traditional oil company businesses. In addition, I think we will have more
arrangements like the partnering with oil service and other related businesses if it can cut costs,
spread risks, increase access and/or increase profitability. I think the lines are starting to blur on
what types of companies are involved in which kinds of projects.
Bud Tower:This is not a trend and is certainly not a long-term threat to the majors. When an
explorer takes an equipment company on as a partner, it is usually an indication that business is
lackluster for one or both of the players.
Briefing: With the conclusion of summer and the busy driving season, and
expectations for a mild winter due to "El Nino", what is your outlook for the
next two quarters?
Joseph Culp: My outlook for the next two quarters remains favorable. Contrary to what the
weather experts are predicting, I believe "El Nino" will have little effect on oil prices. Should "El
Nino" produce a milder winter, that just means people will be driving more and consuming more
gasoline. The real risk lies in there being a "normal" winter since there is currently an inadequate
supply of natural gas and demand keeps inexorably growing. Short-term prospects remain promising
because commodities dominate in the short-term; and prospects remain promising in the long run
because oil companies have grown adept at controlling costs while increasing volume. Moreover, oil
companies stand a good chance of seeing multiples change as the business becomes recognized as
being more stable rather than cyclical.
Holly Gustafson: Over the next six months, we are expecting oil prices to remain strong, buoyed
by strong demand, political uncertainty and a normal level of supply additions. Obviously, unknown
factors, such as a flare-up in the Middle East or a worsening of the impact of the currency crisis in
Southeast Asia could have an impact on the prices. US natural gas prices will depend upon the
weather. However, we are entering the winter with comfortable inventory levels, and absent a
significant EL Nino effect, we expect prices to be in the $2.20-$2.40 per barrel range. Operating
earnings for the major oil companies have increased, year-over-year, in every quarter since the
fourth quarter of 1994. We expect that this trend will be broken in 4Q97, because of a slow-down
in chemical and downstream profits. Already, we are seeing a slippage in R&M margins. Also, US
natural gas prices were very high in the quarter, responding most likely to the shut-down of some
nuclear facilities and a strong US economy. While gas prices should still be quite good in the fourth
quarter of 1997, they do not appear sustainable at 3Q97 nor 4Q96's incredibly high levels. We're
expecting, on average, that operating earnings will be off modestly 4Q96 to 4Q97.
Bud Tower: We are calling it "EL Nino phobia" and feel that the fears of a warm winter are
overblown. Natural gas and oil prices are rising. In 1994, the WTI (West Texas Intermediate - US
benchmark) average price of oil was $17.19 per barrel. In 1995, the average price was $18.41, in
1996 it was $22.14, and we think that we may exit 1997 with a price of $22.50-$23.00 per barrel.
Our contention is that we have these higher prices because oil and gas production is not meeting the
expectations of forecasters. The IEA (International Energy Agency), the most closely followed
forecasting agency for the oil business, is predicting that we will see an increase in production in
non-OPEC countries which will lead to a surplus in oil, especially when combined with increasing
OPEC production. We disagree and think that the IEA numbers are probably biased by Third
World agendas (over-or-underreporting production figures). Based on production figures from nine
of the sixteen majors, worldwide oil production was down 0.7% versus Q2 '97. With worldwide
demand increasing 2%-3% per year, we do not see an oversupply of oil in the near future.
We are in what I consider virigin territory with respect to the price of natural gas. It is currently
around $3.05 per MMBTUs (Million British Thermal Units) which is a price level that historically
has only been reached in the coldest winter months. There are hedges in the gas markets which
indicate that expectations by some are for $5.00 per MMBTUs this winter. People are beginning to
say that EL Nino has peaked early and that fall will be cooler than expected and winter will be
normal. We think $4.00-4.50 is a possible price expectation for natural gas by year-end 1997. The
increases in the stock prices of the oil and oil service companies reflects a sea change in investors'
confidence that oil and gas prices will remain strong.
Briefing: Which companies are you recommending and /or avoiding?
Joseph Culp: We have BUY ratings on the following stocks: Texaco (TX), Mobil (MOB), and
Phillips Petroleum (P) among the major oil companies. In the oil service sector, we favor Reading
& Bates (RB), TransOcean (RIG), Diamond Offshore (DO), and Global Marine (GLM). A
major speculative oil service company we like is 3-D Geophysical (TDGO). Of the independent
producers, we like Apache(APA) among the majors, and Snyder Oil (SNY) among the smaller,
domestic independent producers. Finally, we feel Mid Coast Energy (MRS) is an attractive
pipeline company.
Holly Gustafson: Based on our earnings forecasts and target prices, we favor Mobile (MOB),
Texaco (TX), and Unocal (UCL). Mobile has strong management, good balance, a number of
near-term production projects coming-on, and strong downstream operations. At current prices, it
appears under-valued. Texaco is moving forward aggressively to grow production and increase
earnings. Coming from behind, after years of paying down debt, it appears to have significant growth
potential. Unocal, at current prices, also seems to offer investment opportunity. Since the sale of its
R&M assets, Unocal is now the largest independent E&P company and has considerable exposure
in Southeast Asia, where demand is growing rapidly. In addition, the company will most likely
benefit from the pending litigation involving its patent on reformulated gasoline.
Bud Tower: We have a BUY rating on the refiners, Tosco Corp (TOS) and Sun Company
(SUN). USX-Marathon Group (MRO) will do well among the intergrated companies, if refining
remains strong through the last quarter. We have a BUY on Occidental Petroleum (OXY). We
expect them to announce a buyer for MidCon Gas Services Corp before the end of this year.
I also want to mention one interesting small company, Rentech (RNTK). They are one of five
companies world wide with a technology to turn natural gas into a liquid petroleum product. The
other companies include Royal Dutch Shell (RD), Exxon (XON), SASOL (South African), and
Syntroleum (private). Rentech is in negotiations with Texaco (TX) to commercialize their technology.
We expect the negotiations to be concluded by year-end. This is not a new technology but it thus far
only economical when oil is at the $20 a barrel level. For those who are interested, Rentech will
present at a natural gas-to-liquid conference hosted by Bloomberg in New York on October 29.
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